Fitch said it continues to align Azerenerji's ratings with those of the Republic of Azerbaijan (BBB-/Stable), the sole shareholder, to reflect strong legal, operational and strategic ties between the company and the state, as per the agency's Parent and Subsidiary Rating Linkage methodology.

In particular, the rating alignment reflects state guarantees for the majority of Azerenerji's outstanding debt, the company's strategic importance to the Azerbaijani economy and strong operational links, including tariff and capex approval by the government, and track record of direct state support.

The company is 100 percent directly state-owned.

Fitch assesses legal ties between Azerenerji and the state as strong given that the state continues to provide guarantees for a substantial part of Azerenerji's outstanding debt (about 89 percent of total outstanding debt excluding accrued interest at end-2013).

"Fitch assumes this ratio will remain fairly stable over 2014-2017 and we do not expect any significant changes in the legal links with the state in the foreseeable future, as there are no plans at present to privatise Azerenerji," the agency said.

"The strength of strategic ties is underpinned by Azerenerji's virtual monopoly in Azerbaijan's electricity generation market and transmission segment as well as a 55 percent market share in the country's electricity distribution. This demonstrates the company's importance to Azerbaijan's economy, despite a fairly low contribution to the country's GDP," according to Fitch.

In addition to state-guaranteed debt, Azerenerji received interest-free loans from Ministry of Finance that accounted for another 6 percent of total outstanding debt excluding accrued interest at end-2013.

"The state also continued to provide equity injections of 818 million AZN over 2009-2013 to partially fund its investment programme (around 46 percent of total capex over this period)," Fitch said.

During five months of 2014, the government provided 15.7 million AZN and the company expects to receive 22 million AZN by end-2014 and another four billion AZN over 2015 to 2017, covering around 97 percent of the investment needs for the respective periods.

Fitch expects Azerenerji to continue generating solid cash flow from operations of around 200 million AZN on average over 2014-2017.

However, free cash flow is likely to remain negative over the same period due to significant capital investment plans, according to Fitch.

"A large part of the investment programme is discretionary, depending on the level of available funding from the government. Azerenerji's committed capex totalled 0.8 billion AZN at end-2013. Additionally, we do not expect Azerenerji to pay dividends in the medium term," Fitch said.

Azerenerji's funds from operations (FFO) adjusted net leverage decreased slightly to 5.76x at end-2013 from 5.84x at end-2012, but remained high compared with its peers.

Fitch expects net leverage to remain high, averaging above 6x over 2014-2017, mainly due to gas tariff hikes from December 2013 while electricity tariffs remained unchanged.

Taking into consideration the already high leverage, Fitch would expect Azerenerji to receive state guarantees for any new (currently unplanned) debt in addition to equity injections for specific investment projects.

Fitch views Azerenerji's standalone profile as significantly weaker than its government-supported IDR, due to its financial standing, liquidity and tariff-setting process.

Weakening of Azerenerji's standalone profile is weighed down by substantial gas tariff increase that has not been matched by equivalent electricity tariff change.

Supporting its standalone profile are its modern, primarily gas-fired generation assets, improvements in the household receivable collection rates and favourable prospects for energy consumption in Azerbaijan and certain markets in the region, according to Fitch.

"Azerenerji's overdue taxes amounted to 0.7 billion AZN at end-2013. The company can pay its tax balances with either higher government subsidies or additional debt, which would be negative for its credit profile," Fitch said.

"Azerenerji is exposed to currency risk as almost 80 percent of outstanding debt at end-2013 was denominated in foreign currencies, mainly in EUR, JPY and USD. The company is not engaged in any significant hedging activity to mitigate this risk," according to Fitch report. "Additionally, about 36 percent of total outstanding debt at end-2013 was raised under variable interest rates, raising company's exposure to interest rate fluctuation risks. However, the majority of loans are guaranteed by the state and comprise borrowings from the state. In addition, in contrast to Kazakh tenge and rouble, Azerbaijani manat has remained stable during the last several years."

"Azerenerji's liquidity is weak and conditional on continued tangible support from the government. This is because the company's liquidity comprising cash of 33 million AZN at end-2013 was not sufficient to cover short-term debt of 330 million AZN. About 48 percent of short-term debt is guaranteed by the state and a further 23 percent was lent by the Ministry of Finance, which mitigates liquidity risk," according to the report.

"At end-2013 Azerenerji had available credit lines (related to capex) of 138 million AZN. Although Fitch expects free cash flow to be negative from 2015 due to capex. As capex will largely be funded by available credit lines and new equity, operating cash flow could therefore be partially used to repay existing debt maturities," Fitch said.

Fitch believes that Azerenerji's debt maturity profile does not show any significant spikes in the rating horizon with annual scheduled maturities of around 218 million AZN on average over 2014-2017.

"Nevertheless, with considerable committed capex, government support will be needed to balance future free cash flows, which we expect to remain negative of about 603 million AZN over the medium term," Fitch said.

Azerenerji is the main producer of electricity in Azerbaijan, having on its balance sheet more than 200 substations, with a capacity of 500, 330, 220 and 110 kilovolt amperes, and eight water power plants and 13 thermal power plants.